by Paul Eitelman, Russell Investments
On the latest edition of Market Week in Review, Chief Investment Strategist for North America, Paul Eitelman, and Senior Client Investment Analyst Chris Kyle discussed December U.S. inflation data, the U.S. Federal Reserve (Fed)’s pivot to a tighter monetary policy and the recent outperformance of value stocks relative to growth stocks.
Durable goods prices, shelter costs fuel 7% rise in U.S. inflation
On Jan. 12, the U.S. Labor Department reported that its consumer price index (CPI)—which measures what consumers pay for a broad array of goods and services—leapt by 7% in December on a year-over-year basis. “This shows that U.S. inflation is red-hot right now,” Eitelman said, noting that the CPI rose at the fastest pace since 1982. Even core inflation, which strips out prices from the more-volatile food and energy sectors, shot up by 5.5% last month, he remarked.
Importantly, because the inflation report fell in line with the expectations of most economists, market reaction to the numbers was relatively muted, Eitelman noted. “Fixed income markets in particular kind of yawned at the data,” he observed, explaining that U.S. government bond yields—which have risen sharply since the start of 2022—held fairly steady in the wake of the announcement.
Eitelman noted that the biggest contributors to December’s surge in inflation came from familiar categories, including durable goods and shelter. “Consumer demand has been most concentrated in the durable goods category, given that many people remain stuck at home as the pandemic continues,” he said, noting that ongoing supply-chain issues have hit this category particularly hard. Rising shelter costs are also adding to the inflationary pressures, Eitelman remarked, due to the strength of the U.S. housing market.
On a more encouraging note, he pointed out that so far, there hasn’t been much evidence to show that inflation in the services sector is accelerating. “If this were to happen, it would demonstrate that higher wages were starting to bleed into higher prices across the broader U.S. economy—but so far, this hasn’t been the case,” Eitelman stated.
How many Fed rate hikes are possible in 2022?
As to how skyrocketing inflation is likely to impact Fed policy this year, Eitelman noted that the U.S. central bank has pivoted hard over the last few months toward emphasizing more of a risk-management approach to its monetary-policy strategy. “Fed officials have conveyed there’s some desire to hike rates sooner than originally anticipated, in order to give the central bank the option to raise rates even further down the line should inflation remain at high levels for longer than anticipated,” he explained.
The key takeaway from all of this is that the Fed will probably increase borrowing costs at its upcoming March 15-16 meeting, Eitelman said. “After this, I think it’s reasonable to expect the Fed will continue to hike rates once a quarter—but that’s by no means a certainty,“ he stressed. The number of times the central bank raises rates in 2022 will be highly dependent on how economic growth and inflation play out this year, Eitelman explained. “The omicron variant of COVID-19 remains a risk to economic growth, and there’s also a very distinct possibility that inflation rates could decelerate sharply in the second half of the year,” he stated.
Value outperforms growth as interest rates rise
Eitelman and Kyle concluded the segment with a look at how markets have performed so far in the new year. Eitelman said one thing that’s really stood out is the strong style rotation within equity markets from the growth factor to the value factor.
“Growth stocks tend to be more sensitive to rising interest rates, because investors price cash flows far out into the future. So, higher rates punish the valuations of growth stocks relative to value stocks—and that’s exactly what we’ve seen so far with the Fed telegraphing rate increases for this year,” he explained.
The magnitude of the rotation toward value stocks has been quite large, Eitelman said, with the value factor outperforming the growth factor by approximately 700 basis points, year-to-date, on a global scale. “I think there’s some potential for this outperformance to continue this year, as value stocks are still trading relatively cheap compared to historical norms. In addition, amid expectations for above-trend growth this year, there’s also the potential for better corporate profitability,” he stated, while noting that some of the biggest gains may be in the rear-view mirror.
